Hi guys,I'll say it up-front that there are difficult times ahead for King Pharmaceuticals.With the sudden resignation of the CEO and Chairman Jefferson J Gregory and President Kyle P Macione, questions are being asked about the credibility of the company's management and how a current team would lead KG out of the slump that they got themselves into in the first place. 2003 has been a horrible year for KG and its disappointing that management didn't acknowledge this. From the press releases, annual report and conference calls, one could easily be misled from management's spin that things are great with increased revenues and great cash being generated from operations. But when management hypes the good news and fails to address the problems related to the business, investors should be hearing alarm bells and cast a skeptical eye. Some of the things that that investors should be concerned about is:(1) SEC investigation. Basically KG was caught with their pants down by overcharging Medicaid. Why didn't management have a system in place that would ensure Medicaid and other governmental agencies weren't over charged in the first place? From the 10K it appears that management is still having difficulty in calculating the amount due to Medicaid, since they consider it to be subjective and have to do the calculations manually. How can this be? Unless this is an industry wide problem in which the majority of pharmaceutical/biotechnology companies are also over charging and thus subject to the same investigation, the logical conclusion is that management goofed or at least weren't conservative enough. To date KG haven't satisfactorily addressed this most pressing issue.(2) Inventory problems. Its clear management didn't have a clue on what was happening to channel inventories and let this slip by. One could have seen this by the growth in inventories against growth in revenues for the past 9 quarters on a year-on-year comparison (Y-o-Y) as shown below. Revenue and inventory values are in millions.Year 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04Revenue $258 $282.5 $315.7 $272 $338.4 $370.7 $424.2 $388 $290.6Y-o-Y 42.33% 36.81% 37.21% 6.95% 31.14% 31.21% 34.37% 42.65% -14.12%Inventory $130.5 $148.8 $137.9 $167.1 $209.2 $252.5 $251.7 $260.8 $251.1Y-o-Y 61.96% 71.28% 42.30% 49.81% 60.30% 69.66% 82.42% 56.08% 20.05%As can be seen, inventory has been growing significantly faster than revenues and it was just matter of time before it become unmanageable. Thus it's not surprising that revenue took a hit in 2004 Q1 and wouldn't be surprised on disappointing news in next few quarters. So there's going to be more pain ahead (less revenue and earnings, more write-offs) until inventory levels are at a more reasonable level. This assumes that KG's sales force of 1,300+ individuals continue to sell and maintain the prescription demand. Another alarming trend is the increase in inventory valuation allowance – basically written off inventory which is now at record level of $60 million as at 2004 Q1. If one adds back the inventory valuation allowance the inventory growth is even worse.(3) Special items. This one of the things that management continuously hype in their press release and conference calls when reviewing the income statement. For those who aren't familiar with this, management likes to give both non-GAAP and GAAP income statements to confuse investors. The non-GAAP income statement excludes special items that management determines to be non-reoccurring and does not represent the underlying fundamentals of the business. While there are pros and cons over this, it's obvious that the non-GAAP income statement paints a much prettier picture of how well the company is doing. The problem here is that there have been a lot of these “special items” in 2001, 2002, 2003 and its continuing into 2004. So why is management continuing with this charade? More power to the investor? I doubt it. As an investor, be skeptical on any non-GAAP statements that management spins out. (4) Buying duds. KG has made a name for itself as an acquirer of FDA approved patented drugs and doing a great job of re-marketing. The pros of this is less risk in the drug development cycle, offset by the risk of buying duds and facing generic competition. If management maintains focus and minimizes the amount of duds being bought and/or delays the introduction of generics, then the payoffs can be huge. Examples of smart acquisitions are: Altace, Levoxyl, Thrombin-JMI, Meridian auto-injectors and Adenosine. However, when things go wrong the pain is felt in terms of lost sales, write offs and earnings hit. Some of the drugs that management made a swing for and missed are (numbers are in millions): Drug Name Cost Impairment Other commentsLorabid $91.7 $66.8 $79.8 additional purchase commitmentsFlorinef* $286.5 $111.0 $22.6 additional asset to be impairedNot specified $13.6*Cost includes purchase of Corzide, Delestrogen & Corgard. More recently some of the drugs that are under a cloud due to generics or slowing sales are (numbers are in millions):Drug Name Cost Asset Value CommentsSkelaxin $850.4 $814.4 With: SonataPrefest $118.3 $108.5Nordette $203.0+ $96.0 With: Wycillin & BicillinCortisporin $22.8 $18.3Tapazole $18.2The main concern here is generic threat to Skelaxin, a key product that brought in $179 million in revenue for 2003 and expected to generate $210+ million for 2004. KG took a big risk when purchasing Skelaxin and Sonata from Elan. If Skelaxin generics come out in 2004, then in hindsight the Elan purchase was not a wise one. I'm expecting to see revenue declines, a large asset impairment charge and lower earnings.(5) Change of business model. KG has been initially successful in acquiring drugs and business, increasing revenue and cash which lets them acquire more drugs and businesses. A great business model if executed well and management remains focused. It's a fact of life that not all acquisitions would work out well and the same can be said for every new drug that comes into the pipeline. Any change in a successful business model should be scrutinized particularly when a few recent failings put into bad light the previously successful business model. Recently the acquisition business model hasn't done so well and thus management has indicated that they intend to develop their own pipeline and move away from acquisitions. While this seems logical long term, the problem is KG's small and weak pipeline as discussed below. When management changes their business model, investors should be weary. KG shouldn't abandon the successful acquisition model just because Wall Street analysts think so and thus step out of their circle of competence. It's as if they're starting all over again.(6) Small pipeline. Thanks to Novavax, KG had a recent win in 2003 with an approved drug by FDA (Estrasorb). With one other drug in Phase III trial (biodenosine), one in Phase II (reformulated Sonata) and two in Phase I trials (MRE0094 and T-62) there doesn't seem to be much promise for the future. Management has said they're intending to develop the pipeline and spending $75 million this year on R&D. With those extra research dollars one would think at least one new additional drug should be going into the clinic this year. Moving forward, it's clear that KG needs more drugs going into the pipeline to play the numbers game of trying to get a drug through to Phase III and approved by the FDA. That's going to take time and a lot of money – 3 to 5 years and probably $600 million in R&D expenditure. The concern I have is that KG will be competing against the other big pharmas and biotechs who have greater research ability as well as deeper pockets.So why am I still a shareholder and continue writing about and following KG? Because I believe the company is under valued compared to its peers and I don't believe that KG is a complete lost cause as indicated by the current Enterprise Value of $3.2 billion or $13 per share and change. Current management clearly have their work cut out for them. What has got me intrigued is the catalyst that can propel KG forward - new management. Can new management continue with the excellent past of acquiring products and business that will increase the cash flow while developing their own pipeline? I hope they do, as it has the potential to make KG a great company – but it requires great managers to make this a reality. If I consider 2003 to be a difficult year, then 2004 should be the transition year. There's going to be pain along the way, but it'll be worth it in the long run.Regards,Steveting
Year 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04Revenue $258 $282.5 $315.7 $272 $338.4 $370.7 $424.2 $388 $290.6Y-o-Y 42.33% 36.81% 37.21% 6.95% 31.14% 31.21% 34.37% 42.65% -14.12%Inventory $130.5 $148.8 $137.9 $167.1 $209.2 $252.5 $251.7 $260.8 $251.1Y-o-Y 61.96% 71.28% 42.30% 49.81% 60.30% 69.66% 82.42% 56.08% 20.05%
Drug Name Cost Impairment Other commentsLorabid $91.7 $66.8 $79.8 additional purchase commitmentsFlorinef* $286.5 $111.0 $22.6 additional asset to be impairedNot specified $13.6
Drug Name Cost Asset Value CommentsSkelaxin $850.4 $814.4 With: SonataPrefest $118.3 $108.5Nordette $203.0+ $96.0 With: Wycillin & BicillinCortisporin $22.8 $18.3Tapazole $18.2
Nice write-up Steveting. I was stopped out due to the big price drop. I will revisit King at some time in the future depending on how a couple of other stock investemnts I am working with or studying work out.-- Mark --
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